The end of jam-tomorrow culture

By Felix Salmon

April 30, 2009

There’s a great discussion going on in the comments of my financial literacy post about the question which 93% of Americans got “wrong”: what’s better, paying off a $1,000 appliance at $100 a month for 12 months, or waiting a year and then paying off a $1,200 lump sum?

The “right” answer is that the lump sum option is better, since it carries a much lower effective APR, but my point of view is that in the real world someone choosing the second option isn’t going to diligently put $100 a month into an interest-bearing savings account and thereby make a bit of extra money, and instead is just going to wind up owing $1,200 in a year’s time — basically just kicking the “how do I pay for this appliance” problem down the road, and making it $200 worse.

I myself would of course choose option B, but as for the poor little feckless working class, they’re not really to be trusted with money, so they’d better go for option A.

But that’s not what I’m saying at all. The point is that there’s a hidden assumption here: that option C — which is simply writing a check for $1,000 — isn’t on the table, and that the purchaser doesn’t have $1,000 to pay for an appliance. So no, I myself would not choose option B, since I would choose option C and just pay for the thing.

On the other hand, Dsquared makes the very good point that a bit of empirical evidence would be very useful here, and that having this debate in the theoretical stratosphere really helps no one:

Is there actual evidence that people who own a load of stuff on installment credit have better financial outcomes than people who have a bunch of debt?

I don’t know whether there’s evidence to that effect, but I would love to see what the evidence is, and I have to say that my intuition is that, yes, people on installment credit do have better financial outcomes than people with a lot of undifferentiated lump-sum debt. But I might be wrong.

I also got a great email from Mike, of Rortybomb fame, who points out that this question is applicable not only to the poor but also to (a certain subset of) the rich:

Keeping the logic the other way: Let’s say instead of paying, you could get paid at your job $100 a month for 12 months, or get paid $1500 at the end of the year, and the interest rate is 1% a month. Option 1 is a net present value of ~$1125. Option 2, the one time payment, is a NPV of ~$1330. (ii) is the correct answer, it is worth more.

Unless your company goes bankrupt in month 11. (ii) is also the payment all the Wall Street kids took with their ‘no payments except for the yearly bonus’ option. And we wonder why they whine about not getting bonuses – time-value told them that was the smartest choice, way smarter than getting smaller payments throughout the year! How much better off would economics/finance be if they realized that people’s value of security and consistency wasn’t a defect of their puny minds not being able to handle utility theory?

More generally, the whole credit bubble was, in effect, what happened when the world started paying huge amounts of money today for jam tomorrow. Anybody choosing the $1,200 lump-sum repayment is basically making a bet that even though they can’t afford $1,000 today, they’ll be able to afford to pay $1,200 in a year’s time. But the fact is that people who can’t afford $1,000 today generally can’t afford $1,200 one year later, which means that most people taking that option are in a sense deluding themselves. Just as bankers deluded themselves that their year-end bonuses were money in the bank.